The short answer is simply that Scale Matters.
The long and somewhat wonkish (although perhaps more interesting) detailed answer relates to a host of factors, but Scale is related to almost all of them either directly or indirectly.
In my answer below, I took a look at actual numbers out in the real world to understand the nature and magnitude of various manufacturing cost components and see how they vary between China and India.
Using this case study of one fairly typical Chinese exporter, you can get a better sense of the fundamental factors that drive the key manufacturing differences between China and India. You will see these themes recur throughout the case study below:
Scale — Scale Matters! I cannot emphasize this enough. Manufacturing is all about repetition which leads to consistent incremental improvement. Manufacturing scale also allows you to spread fixed overhead costs across a wider base. China has done a great job of creating massive scale across a wide array of manufacturing sectors while India’s antiquated regulatory framework actually discourages entrepreneurs from scaling up, effectively preventing them from having any chance to be successful in the ultra-competitive global markets.
Clustering — China has encouraged the development of manufacturing clusters where suppliers, specialized services and financing (formal and informal) are all located side-by-side in close proximity, creating an environment of both intense competition and cooperation that allows manufacturers to shorten development cycles and upgrade their efficiency or improve product quality over time.
Labor cost — Although Chinese manufacturing labor cost is almost quadruple that of India’s, it is also significantly more productive – and productivity is what really matters. China’s productivity advantage is derived from a combination of better human capital (education, training etc.), more invested capital (e.g. machinery to automate certain repetitive tasks) and more advanced manufacturing processes (i.e. experience). Also notable for export businesses is how small labor is of the overall cost pie.
Land acquisition — Favorable policies around land acquisition make it easy for Chinese entrepreneurs to locate and build large-scale factories. In sharp contrast, investment projects are often held up (or cancelled) in India due to lack of ability in acquiring a large enough tract of land. You cannot simply split your factory in two pieces and expect to get the same level of efficiency. Scale Matters!
Infrastructure and logistics — China has done a solid job of providing relatively efficient and low-cost transportation, electricity and energy, especially in its export-processing zones near the major ports. Clearly this is another area that India needs to invest in.
Taxation — Another area of support for its export sector was the reduction and simplification of taxes, particularly in the Special Economic Zones. China also has a unified tax system, which removes the inter-state/province bottlenecks that you often see in India.
Macro stability — The question raises the topic of currency, which I view as part of a larger category: the general macro-economic environment. Currency does matter, but it is less about whether you have a policy to keep your currency “under-valued” than being part of a broader framework that emphasizes a minimum level of stability that investors and entrepreneurs need to function at a level that can maximize their full potential.
For India, some of these factors can be easily overcome and some are more difficult. Some are already in process under the Modi administration but others are held back by the country’s divisive politics. Down below I offer some suggestions on how India can close the manufacturing cost and productivity gap with China, although I will note that offering suggestions is easy; it is implementation that is the challenge.
I would also like to add that I believe that the best way for the two countries going forward is through cooperation not competition, especially as it relates to manufacturing. In the modern era, global trade and manufacturing is not a zero-sum game: India’s gain is not China’s loss and vice versa. In fact, as China makes its move up the value chain, the only other country with the scale to fill its shoes is India. Figuring out a way for the two countries to work together in a complementary manner has the potential to define the world economic order over the course of this century.
So if there is one other message besides how ”Scale Matters” in manufacturing that I want to leave you with it is that this should be about “India and China”, not “China vs. India”.
A case study on Allan International
Allan International is a small export-oriented manufacturer of household appliances based in Hong Kong. I chose Allan because (i) it fits the typical profile of a Chinese export-oriented manufacturer — often owned and run by Hong Kong (as it is in this case) or Taiwanese entrepreneurs (ii) it is publicly listed on the Stock Exchange of Hong Kong which means its financials are publicly accessible and (iii) it is a company I am somewhat familiar with.
These export businesses are primarily non-branded manufacturers that produce goods that are branded by multi-nationals and marketed overseas. In Allan’s case, it produces items like blenders and electric kettles for customers such as Philips, DeLonghi and SEB SA:
I pulled numbers from its most recent annual report and made some estimates to derive a breakdown of its significant manufacturing costs [1]:
Materials and components. As is typical of these export businesses, the bulk of the final product cost is in intermediate materials and components that are brought into the factory to be manufactured or assembled into the final product. For Allan, one of their biggest cost items is a small motor that would be produced by a company such as Johnson Electric that is likely imported into China. Other components would include commodities like stainless steel, plastic, glass, basic electronics and packaging.
Scale and Clustering are the keys to keeping this bucket of costs down. Scale gives manufacturers more bargaining power with their suppliers and also makes logistics more efficient. Industrial clustering means that many of the necessary intermediate components are located in the local area, which also helps with efficiency.
Infrastructure also matters as many of these components are imported in from other countries or provinces and later, the finished products must find their way back to the port to be shipped out to the end markets. It is not only a cost issue, there is a time component as well.
Labor. Manufacturing wages and compensation is the next-highest cost item. The first thing to note here is that it actually makes up only 15% of the total cost basket. That means that even if your unit cost per labor output is double that of a competitor’s, this only adds 15% to the total cost of sale.
The more important thing to note is that it is not labor cost per hour that matters, but labor cost per unit of labor output. In other words, if your hourly wage is double but productivity is triple, you are actually more competitive in labor terms. China’s manufacturing labor is significantly more productive than India’s so even though hourly compensation is almost 4x higher, they do not suffer a manufacturing disadvantage in this area. The same exact thing can be said for American compared to Chinese manufacturers.
In the case of Allan, the company has demonstrated consistent productivity improvement [2] in the amount of output per laborer (measured by revenue) and by doing so, it has been able to maintain profitability despite hourly labor costs that have risen by more than 3x over the last decade:
In its annual reports, the company’s management discusses how it was able to improve productivity over time: through a sustained effort in improving production methods and manufacturing processes through methodologies like Six Sigma, as well as investments in capital (robots and equipment) to automate certain processes over time.
Another meaningful difference between China and India are the country’s respective labor laws and protections. China has relatively little regulation around labor wages and safety while India has dozens if not hundreds of laws (some dating from the British Raj era) that effectively make dis-incentivize them from hiring more than a certain number of workers. Remember, Scale Matters! A mass manufacturer with fewer than 100 employees simply cannot be competitive in large industries at a global level.
Factory costs. Factory overhead costs primarily consist of land, machinery depreciation and utility costs. The most meaningful difference between China and India in this category lies in the ability to procure space to locate a large factory and this is largely due to differences in land acquisition processes. Because of the importance of Scale, large plots of open space are required for manufacturing that is competitive on a global level.
China has gone out of its way to secure land for export manufacturers, sometimes at the expense of locals. India is pretty much the opposite in this regard with local protest often leading to massive project delays or outright cancellations.
Infrastructure also matters here. Modern factories run mainly on electricity and China’s power grid is quite robust, in stark contrast to India’s blackout-plagued grid. Backup solutions are only temporary fixes because small-scale diesel generators are several times less efficient and more costly than large-scale centralized electricity generation. This is clearly another area that India needs to invest in.
Shipping. This relates to the process of getting intermediate components and materials to the factory and then getting the final product from inland to the port and then getting the product onto a ship. China has done a good job of building nice roads and ports to make the transportation and logistics process relatively efficient. Scale helped here.
We all know about India’s poor-quality transportation and logistics infrastructure but equally meaningful are some of its antiquated regulations, especially as they relate to sales tax. For example, it is very common at state borders in India to see trucks lined up waiting to be processed by local authorities and/or pay state sales taxes:
Imagine having to do that two or three times as intermediate components or finished goods make their way from suppliers and to end markets. It is not only a cost issue, but a time-to-market issue as this process could add weeks or even months to the process. This simply will not cut it in the ultra-competitive global export markets.
Currency. You will notice that up to this point I haven’t discussed currency. I did this purposely because I wanted to emphasize that it is not the major source of China’s manufacturing competitiveness. An “under-valued” Renminbi would only directly impact the labor and factory/land components which makes up only a quarter of the product cost in Allan’s case. The “materials and components” make up the majority of the product cost and to the extent these intermediate components are imported from other countries, they are merely pass-through costs — the exchange rate of the origin country (e.g. Japanese Yen or South Korean Won) matters more in these cases.
More meaningful is the establishment of a macro-economic regime that is stable so that the factory owners can focus on their manufacturing operation instead of wondering what the exchange rate might be next year or whether their financing costs are going to spike due to inflation. In this regard, China has done a much better job than India and this is where India’s policymakers need to focus.
How do you make “Make in India” successful?
This is of course the critical question. It deserves a full answer and I plan to put something together at some point. But for now, using the learnings from the case study above as a guide, let me humbly offer a few areas where Indian policymakers need to focus:
Fix antiquated labor laws that dis-incentivize manufacturers from scaling up
Fix interstate bottlenecks by passing the Goods and Services Tax Bill
Fix the land acquisition laws to streamline the process
Foster a stable macro-economic environment, particularly as it relates to the Rupee exchange rate and domestic inflation
Invest in transportation and power infrastructure, starting in a few select regions along the coast. Early success in these special economic zones can fund future investments in other regions. There is a compounding effect.
Tackle corruption. Manufacturers rely on significant coordination with others (logistics, infrastructure etc.) so corruption in one part of the economy can have significant negative repercussions on honest entrepreneurs (for more, please see Which country is more corrupt, India or China?).
Fortunately, none of these fixes are big secrets and in fact, India has already made good progress to address some of them e.g. Raghuram’s recent stewardship over the macro-economic environment. Unfortunately, many of these fixes are being held up by divisive political squabbling.
But India does seem to be on the right path ... although this is also not to imply that India follow China’s exact path. While the high-level objectives might be the same (e.g. getting to Scale), India will need to figure out its own path on how to get there and take into account its unique history, legacy and culture. For example, on the question of labor regulation, Chinese policymakers have made the choice to sacrifice labor rights in the name of efficiency. Even if this were tenable for Indians, there is no guarantee that implementing the same policies would yield the same results. So while the story of China’s rise in manufacturing offers some clues and suggestions, India will need to ultimately decide what applies and what doesn’t. And therein lies the ultimate challenge for policymakers.
Regardless, I reject any notion that India lacks the potential to become a globally competitive manufacturer and a fully developed country one day. As I discuss in elsewhere, every nation has ample entrepreneurial energy and it is more a question about how this energy is directed. Thus far, much of India’s abundant entrepreneurial energy has been misdirected as a result of poorly designed / legacy regulation, lack of coordination and lack of general macro-stability. Where these issues aren’t present, such as its IT/BPO industry ... or Indian-American success in Silicon Valley ... we can catch of glimpse of what the Indian people are capable of.
Notes
[1] Cost of goods sold bucket. Top-level figures can be found in the company’s public filings. Here is their latest annual report.
[2] This chart shows figures through FY2013 (the year ending March 31, 2013). During this period Allan achieved consistent productivity improvements, but over the last three years, its productivity has stagnated. Some of this is due to stagnant end markets (especially Europe) limiting revenue growth although a portion of this is probably attributable to reaching the limits of being able to wring out labor productivity without a radically different manufacturing approach (e.g. full automation vs. “semi automation”).
This was originally published on Quora in February 2016.